(Mar 6): As the number of reported Covid-19 cases outside of China continues to rise, so do broader investor concerns about the potential economic impact of the virus. The prevailing market narrative has shifted swiftly from the coronavirus being a predominantly China issue to it being a global problem that might result in recession.
But the repricing of growth expectations and risk across asset classes due to the coronavirus has been far from uniform (Table 1).
Industrial commodities — most notably oil — and commodity sensitive equities and currencies have been among the hardest hit. Within equity markets, one of the most notable and surprising features of market price reaction in recent weeks has been the material outperformance of on-shore Chinese equities.
Traditional safe havens such as government bonds have outperformed significantly amid the flight to safety, with yields sharply lower and at all-time lows across a number of major countries.
Meanwhile, US high yield bonds in aggregate have fared considerably better than equities in the sell-off despite their sensitivity to a growth slowdown, exposure to consumer spending and usual positive correlation to oil.
To put the scale of last week’s market action in an historical context, the weekly fall of over 11% in local currency terms for the MSCI World was the third largest over the past 50 years and the biggest weekly loss since the financial crisis (Table 2). The VIX Index, Wall Street’s so-called ‘fear gauge’, closed the week at levels not seen since the European debt crisis.
Are investors overreacting?
We should acknowledge the high degree of uncertainty that surrounds the potential global economic impact of the coronavirus. That uncertainty is the principal driver of the increase in volatility and the drawdown in risk assets. The transmission mechanisms of the virus to economic demand are nuanced. But in simple terms the potential impact is significant because the virus restricts nearly all parts of the economy via the flow of people and the flow of goods.
As the virus spreads further across Europe, US and elsewhere, the probability that it could ultimately lead to a more significant slowdown in global activity is increasing. Efforts to contain the spread of the virus by closing businesses and imposing quarantine are themselves potentially negative to short-term growth potential.
Significant as the potential impact is, we do not yet believe that the virus represents anything like the structural downward shift in global growth that was the result of the financial crisis, but accept that history does not present many helpful guides when it comes to the current scenario.
In our view, the dislocation between market reaction in US equities versus US High Yield bonds suggests that strong flows have weighed on equities in particular. Our read through of the relative strength in High Yield is that credit investors do not yet believe that the coronavirus is an event that threatens a more material increase in corporate bond defaults.
Nonetheless, the distribution of potential outcomes for global growth is changing. This mainly reflects the danger that the market selloff becomes self-fulfilling, with consumer and business behaviour materially curtailed by newsflow and by the drawdown in risk assets.
Is it just the coronavirus driving risk assets lower?
In our view, one of the drivers to recent equity falls was the potentially dangerous circularity of the virus and perceived US political risk. Falling equities and any deterioration in economic conditions are likely to boost the chances of a more progressive Democratic Party candidate such as Bernie Sanders winning the US presidency, for which investors are understandably demanding a higher risk premium.
But the decisive victory of Sanders’ principal opponent for the Democratic presidential nomination in the South Carolina primary on Feb 29 — centrist candidate and former Vice-President Joe Biden — provides at least a temporary circuit breaker to that negative circularity. Should Biden gain further ground ahead of the July Democratic Convention, investors will begin to unwind some of the risk premium that has been priced in for the threat to corporate profits from the Democratic Party. Super Tuesday on March 3 — in which 14 US states hold their primaries — is therefore a key date. Biden again notched a string of victories while Sanders won delegate-rich California. So for all the talk of the coronavirus, perceptions of US political risks are likely to be a major driver of US risk asset returns in the coming months.
How long and how much could the coronavirus impact global economic growth? We assume for now that the rate of growth in new coronavirus cases in China will continue to slow. But it is not a given. The flash PMIs for February — the first data points we have for a whole month of the virus impact — show Chinese activity across both manufacturing and services slumping to all-time lows with levels significantly lower even than the financial crisis. We currently estimate that annual demand growth in China will be around 50 basis points (bps) to 75bps lower than pre-virus consensus forecasts of 5.8% with the impact firmly focused in calendar Q1 and Q2.
But we should not forget the secondary economic impact of the coronavirus in China via the disruption to global supply chains. We are likely to hear a lot more about it from global corporations in the coming weeks. According to a recent report (Business Impact of the Coronavirus by Dun & Bradstreet) over five million companies globally — and some 94% of the Fortune 1000 — have one or more suppliers in the area of China affected by the coronavirus. China is returning to work and activity levels are rebounding. But as positive as that is, a significant degree of disruption for global corporations is likely for weeks to come.
Outside of China, lower population densities and generally strong public healthcare systems (excluding the US) are likely to limit both the spread of the virus in developed countries and its subsequent mortality rate. But the disciplined and effective response of the Chinese authorities to-date is also at the upper bound of what might be expected in terms of response from any given country.
At a minimum, the continued rise in cases outside of China lengthens the period during which the virus is likely to impact global growth and remain a source of heightened uncertainty to investors. The increase in uncertainty has clear negative implications for overall shortterm demand, for forecast corporate earnings — and for the equity multiple that investors are willing to pay for lower profits growth amid such uncertainty in the short-term.
Based on the progression of the virus in China, our view is that the disruption to growth and risk asset volatility are likely to remain elevated well into Q2 while the number of cases in major economies continues to rise. Todate consensus forecasts have cut only around 20bps off global growth expectations for 2020 to around 2.5% around 4% off 2020 global earnings growth forecasts, reports Refinitiv and Citigroup.
We believe it is the length more than the severity of the coronavirus downturn that matters most. If the impact of the coronavirus is still being felt into the second half of 2020, both consumers and corporates are likely to change their behavior and the coronavirus ceases to be a short-term earnings story and starts to become a credit story.
If it is only a few weeks into Q2, we believe that companies and consumer behavior will be held in check over the short-term but the underlying momentum is unlikely to fundamentally change. In those circumstances we see the potential for a strong demand rebound in the second half of the year that is likely to be accompanied by a more forceful return in investor risk appetite.
In short, our base case remains that the coronavirus represents a meaningful demand and supply shock, but one that is unlikely to have a structural impact on growth potential or the long-term equilibrium interest rate. While the precise timing of any demand rebound is not easy to pinpoint in the context of the coronavirus, we see sufficient support to believe that growth momentum will return around mid-year. It has the potential to do so strongly.
Evan Brown is Head of Multi-Asset Strategy at UBS Asset Management
